Of course, to spice things up, a high P/E can also mean the opposite of trouble; it may just be the marker of a true growth industry.
Before you can spot red flags, you need to know what is normal for the P/E. For instance, each sector’s average P/E reflects the speed of expansion in that industry, how cyclical it is (industries that traditionally move from boom to bust every 6 to 10 years tend to have rather low P/Es), and its rate of technical renewal. Average P/Es also shift depending on the position in the economic cycle. For example, construction company shares will be far more highly valued as we enter an upturn than they are with a slow-down approaching.
To find P/E ratios for whole markets and different sectors check tables such as the Actuaries Share indexes in the Wall Street Journal or Yahoo! or Google Finance, or look for an extra line under each sector in the straight share price statistics. For prospective P/Es for entire sectors and markets, turn to sell-side financial analysts.
It’s also worthwhile watching for the highest or lowest individual P/Es within each sector. If a P/E or prospective P/E is lower than the norm for a sector, we say the share is at a discount—it’s relatively cheap. Conversely, when an individual P/E is higher than the norm, we say the share is at a premium, that is, relatively expensive. But, in fact, the vital element in determining whether this company is truly a bargain are the reasons for the current valuation . . . and their validity.